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The Puerto Rican Bond Plot Thickens

The federal government is now putting under its microscope mutual fund companies that have invested billions of dollars in Puerto Rican municipal debt, according to several news reports last week. As this blog has noted over the past several weeks, the storm of losses created by Puerto Rican municipal securities has moved from the island commonwealth and is now hitting investors in the U.S. mainland.

In the latest news, the Securities and Exchange Commission is making inquiries into several mutual fund companies to determine whether the funds investing in those municipal bonds adequately disclosed the risks involved in Puerto Rico debt. The SEC’s probe is also aimed at understanding the potential effects on the market if Puerto Rico, which has issued $70 billion of municipal securities, suffers a further downgrade to junk status or if it defaults, according to a report last Thursday in The Bond Buyer, an industry newspaper.

“Regulators have been ramping up their scrutiny of investing and trading in Puerto Rico’s $70 billion worth of outstanding debt, as the island’s credit rating hovers just above “junk” and its bonds trade at low levels, threatening to spread losses broadly through the $3.7 trillion municipal-bond market,” according to the Journal report. “Three-quarters of municipal-bond mutual funds own some debt issued by Puerto Rico, one of the biggest issuers in the muni market due to its tax benefits and often higher yields.”

Puerto Rico has a struggling economy and is facing a staggering burden of unfunded pension liabilities. But some municipal bond fund managers have been gobbling up Puerto Rico’s debt like they were kids with a bag of candy on Halloween, according to several reports. And the problem may be that investors were misled or confused by the name of the bond funds that they bought.

In the end, it’s investors, not bond managers, who are left with a bellyache.

According to The Bond Buyer: “Franklin Templeton’s “Franklin Double Tax-Free Income A” fund is 61% Puerto Rico debt, while Oppenheimer Funds’ “Oppenheimer Rochester VA Municipal A,” a Virginia-specific fund, is 33% Puerto Rico debt. Oppenheimer also runs several more state specific funds for North Carolina, Maryland, Arizona, and Massachusetts which each hold more than 20% of their assets as Puerto Rico bonds.”

The returns for investments that stock brokers pitch to Mom and Pop investors as safe and secure have been dreadful, according to The Bond Buyer. The Franklin Double Tax-Free Income A fund is down 15.23% since June and down 13.74% year-to-date through Oct. 23. The Oppenheimer Rochester VA Municipal A fund is down 14.60% since June and 13.05% year-to-date.

Indeed, the municipal debt situation in Puerto Rico has deteriorated so badly that investment professionals believe that only hedge funds, which have huge appetites for risk, should be in that space. According to an article in Barron’s by Michael Aneiro, an investment strategist for UBS at a conference last week said, “I would be really careful trying to play Puerto Rico or trade it. Hedge funds don’t own Puerto Rico. They rent.”

That’s some cynical call by UBS, which is at the center of the Puerto Rico bond storm as it sold and packaged some $10 billion of the securities over the past ten years, selling them to local clients in closed end funds that are now collapsing.

Did UBS give similar advice to its clients over the past year when the firm’s brokers were selling the closed-end, municipal bond funds? Did UBS give similar advice when brokers recommended that clients borrow money on margin or against their homes to pay for the bond funds?

Most likely not, although definitive answers to those questions will take months and years to come to light. Unlike UBS, Oppenheimer Funds or Franklin Templeton, Mom and Pop investors who rely on municipal bond funds to fund retirement don’t have the luxury of years to wait around hoping their investments rebound. They want answers now, and so does, apparently, the SEC.

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